Roman: Welcome back to the Sage Advisory podcast. It is beautiful rainy day here in Austin, Texas. I'm here with my good friend Komson. How are you, man?

Komson: Doing great.

0:14

Roman: So today we're going to talk about decision-making. There's a lot of decisions that investors could be making in the course of their investment journey. What are some of the big decisions that investors should be aware of?

Komson: Thanks Roman. I think there are really four decision points for an investor. So first is forecasting. So you have to make a decision on what the future will look like, what is a future state of the world? And so for example, here, we look at, okay, well state of the world could be economic growth? What does that state of the world could be? You know, what are the markets pricing in? So valuations, policy? We mentioned this before, also market psychology and sentiment. So those are the kind of the things that we have to forecast, what are those things going to look like in the future? The second thing we have to think about is, okay, now, given the state of the world, what assets will perform well in those environments? And so a big part of our process is getting what we call these “key risk decisions” correct. And what I mean by that is, once we know what is going to happen, or we forecast what's going to happen in the future -- what's going to happen to interest rates? So what's our duration, positioning, what is our credit sensitivity? What's our equity, beta? And then from there, we have to make a decision on how to express that investment, and that key risk decision, into tactical tilts. So an ETFs -- we may overweight or underweight to be allocated out of certain ETFs, certain regions, sectors, and styles.

1:39

The third big decision point is sizing. So now that we know how to position for that state of the world, what is the risk/reward? How big should we be? What is the position, size of that particular tilt? What is the risk for that one particular tilt? And how does it relate or correlate to other tilts in the portfolio? And then the fourth one is evaluation: how do we judge success? And that's a harder one. Then I think that, you know, that a lot of folks think it's, you know, not only how do we judge success, you know, we can look at return, but did you go about the decision the right way? And how do we judge success before you've achieved success. So, while you're in a certain investment, and it behaves a certain way, let's say you hit market volatility, and it behaves a certain way. I think that evaluation, so making a decision on whether something is a success or not, I think that's a big thing.

2:32

Roman: So that is a -- Wow, that was awesome. There's a lot there. So there's four main concepts that you were talking about. It sounds like there's kind of this hierarchy that exists of, you know, things that you need to look at. So I want to, I want to zone in on each one of those four components a little bit more. So that first component that you're talking about -- forecasting, looking, okay, you got to make a decision about what's going to happen in the future. And then based on that, you start rolling back to the present. So can you explain a little bit more about what surrounds that decision of forecasting?

3:02

Komson: Forecasting is really just thinking about, really trying to predict the future. So you can do it in a couple of different ways. You can do it in qualitative or quantitative way. So, quantitative being traditional forecasting, economic forecasting. The other one is based on experience. So we have a lot of experienced members, a wide variety of experiences.

Roman: If I hear what you’re saying correctly, the quantitative approach, you know, relies a little bit more on the on the numbers, what the numbers are telling you. Qualitative, like you're saying, is taking the idea of, Oh, we've seen this before. And this time, we've had this experience and making more of a subjective, you know, kind of opinion of a certain sector and we're, what you're saying is that, what we do is we kind of blend a little bit of the two together.

3:50

Komson: And I think the thought behind that is that while economic, even econometric techniques, are really powerful, and we do use a lot of those, there are certain things that can't really be modeled, or there's a small sample size. And so when you're looking at the prior three recessions, you know, you can make you an assumption on what's going to happen on the next recession, what maybe caused the next recession, how certain things are going to behave, you know, asset classes and whatnot, but that's just three samples. And so that's kind of the wisdom part. And that's where, you know, we have to think outside the box and say, Okay, well, here are the things that are a little bit different this time, maybe it's not going to come from the real estate market, you know, in terms of a credit crisis, because oftentimes, we've corrected for those. But I guess what I wanted to say is that, there's a little bit of a wisdom part of it. And I think that's where, you know, people say, art and science.

4:45

Roman: Yeah, it's, that's one of the things about investing in general is, at the end of the day, you have to make a judgment call, and you have to risk that your judgment is wrong in some way, shape, or form. Moving into kind of that second component that you were talking about -- oftentimes I get the question from advisors: is it better to be defensive? Or is it better to be aggressive? And you were talking about something called the “key risk decisions” that we're focusing on. Can you tell us a little bit more about the idea behind those key risk decisions?

5:20

Komson: Well, we think that those decisions, those key risks are the main drivers of a portfolio and a strategy’s return over time. So, for example, getting your credit exposure, getting your interest rate exposure, getting a yield curve exposure correct in a fixed income portfolio is, we think, dwarfs the importance of selecting the correct security. Now, in an ETF portfolio, all there are, are sector bets. You don't get the opportunity to select securities. But we do that in our cash bond portfolios, but we still even in our single security portfolios, our institutional accounts, still rely on, you know, these key risk decisions. And I think that, you often hear, kind of zooming out -- that your asset allocation determines most of your long-term return. That's the same concept. If you're a 60/40 portfolio, 60% equities, 40% bonds, your long-term returns can be driven really by equity risk. We do aim to be to be tactical, and how we define that is a three-to-six month tilt, one way or another. And so we think that over that three-to-six month time frame, that asset class, that segment, and that sector allocation also is a kind of paramount importance. And so I guess that's what I mean by getting those right.

6:40

Roman: Yeah, that was great. I mean, essentially, what you're saying is that you can boil down the judgment call into buckets of making decisions, whether that's your duration management, your yield curve positioning, your credit exposure on the fixed income side. On the equity side, whether that's your large cap, small cap, what sizing, how much are you exposed to those types of -- value or growth -- those types of decisions. So, that's what you're saying, is at the market segment level, that’s the more important driver of the return than choosing individual securities or something.

7:22

Komson: So we have a chart that shows this phenomenon. It's a ranking of asset class returns on a year by year basis. And it also shows the distribution of the best and worst managers in each of those asset classes. And so we found that if you are the best manager selector and you meet, you manage to find the best manager in, call it, the worst performing asset class, it still wouldn't really match the returns of what you can get in the best asset class or highest-performing asset classes of that time period. And so we just think that --

7:57

Roman: The asset class is basically the more important driver of the decision. I remember the study that you're talking about is essentially trying to make the case that the manager selection doesn't really matter. If you were, if you were in the wrong market segment today, that year, no matter what the markets, choosing to be in the right market segment is dramatically more important than selecting the right manager who happened to be in the wrong market segment. So we've covered basically, you've got a forecast, you've got to look at the state of the world, and you've got to assess where you think it's going, then you've got to adjust for what we're calling the “key risk decisions” in your portfolio, so that you can limit the things that could go wrong. What's next?

8:44

Komson: I think it's sizing. So “what is a risk and reward?” is not enough to have your forecast be correct. But you want your money, and you want your allocation, to be in the areas with highest potential because no one has a 100% correct forecast. So every investor knows they're going to be wrong. I think the best investors know how to size their positions in areas where they have some cushioning for if they're wrong, or they have the most upside when they're right. And so we try and measure the potential of every bet that we have, then we size those accordingly. And we use other risk management methods as well. And so that's really sizing.

9:20

And then the fourth one is evaluation. So I think that's making sure to stay true to your values, judging success in terms of knowing why you got into a trade, why you got into an allocation, why you got into a tilt. I think that that sounds really simple. But when every single day and every single week as an investor, you have headlines, changing events, in terms of earnings policy, you have to make sure that those events matter, and they’re not noise. And so I think that, are they essential to the views that you have that have driven you to be in that position?

Roman: From what I hear you saying, basically, the sizing is the expression of your judgment call. What are some of the mechanisms that we use to prevent us from making bad decisions?

10:11

Komson: You know, we think that -- just zooming out -- really any decision in investing, information typically is not going to provide you an edge. So a lot of the macro information, economic releases, are widely available. And so your edge is not going to be the information that you have as an investor, your advantage is going to be how we process information and act on that information. And so the key for us, and you talk about safeguards and ways we can mitigate bad decision-making, is to eliminate the negative effects of cognitive biases. And so what I mean by that, so cognitive bias, and there's a lot of literature on this, Daniel Kahneman wrote a book called “Thinking, Fast and Slow” on cognitive biases, or mental shortcuts. And so, and they're good, I think that on the whole, they're good, these mental shortcuts are really necessary because we live in a world where we have unlimited amounts of information. And so we have to reduce that information in order to make decisions. So we come up with a rule of thumb. So you do that across your life. But I think in as an investor, you have an open system of all information in the world that affects a particular investment, and so you have to come up with mental shortcuts, or an investor has come up with a mental shortcut, in order to be able to invest effectively. Now, that blurred vision of the world that, you know, you're not taking in all information, you're taking, you having a rule of thumb can result in really some key fallacies and decision-making. And so the strategies that we use to limit those are as follows. And I'm going to reference a book that really, I think it does a really good job of illustrating decision-making.

11:48

It's a book called “Decisive” by Chip and Dan Heath. And they have a process, and I'm going to use it as our framework to illustrate how we make decisions. It is called the WRAP. So it's an acronym. So “W” stands for widen your options. “R” stands for a reality-test your assumptions. “A” is attain distance before deciding. And “P” is prepare to be wrong. And so the first one is widen your options. So, you know, you want to have a wide-ranging set of opinions and wide-ranging experiences before you make a decision. Ask someone who has solved that problem before. And so that's the reason for our investment committee. So the investment committee consists of folks from all over all over, different asset classes, folks that invest in fixed income, ETFs, macro, micro. And so having kind of a wide variety of opinions really helps us widen our options. The second one is reality testing our assumptions. And so when we, when we look at the risk of the portfolio, which really, the risk in your portfolio is where the rubber meets the road. We look at the average risk. So oftentimes, people use standard deviation or value at risk or whatnot, that's that just tells you the average risk of your portfolio. We also try to look at the extreme risk of the portfolio. So stress testing the portfolio based on historical scenarios or future scenarios, that we think are going to happen. So we that's how we reality test a portfolio and decisions that we make.

13:18

The third is attain distance before deciding. And that's just sticking to core principles. And it kind of goes back to reality testing of risk management, and deciding beforehand, you know, what are kind of the parameters, were the trip wires by which we make decisions. And so the fourth one is prepare to be wrong. And it has to do with the trip wires I mentioned. What trip wires are, when we initiate a view, we initiate a tilt, we also identify three or four key risks that would cause us to change our view on that. And so, for example, we really liked Japanese equities for some time in the past because they had really accommodative monetary policy. And so one of the trip wires is, was with a specific language out of Bank of Japan around their interest rate target on the 10-year point or any other kind of policy measures. Whenever they would comment on that, we would cross check it against a trip wire. It is really a checklist method. But it’s a basic thing. But I think sometimes it allows you to weed through the noise. And so that's really the four buckets. But it kind of illustrates the ways we, you know, we use different strategies to limit that decision-making.

14:35

Roman: Yeah, that was great. So, I mean, the importance of what that last part of what you said, I think, is so paramount, because the trip wire is essentially a way of you returning to your original thesis at the outset of the trade and saying, has something changed based on this? Because what you're talking about is the challenge in investing. You tilt into something right, you buy a trade, you go long something, and then volatility starts setting in. And markets start doing what they do. And all of a sudden, the value of what you own, let's say, has dropped. Now, logically speaking, if everything is the same, you should be the happiest person on earth, because your thing just went on sale. But what you're talking about is, we have to then return to the thesis and then say, has parts of the original thesis changed? And if so, now we have to adjust, right?

15:29

Komson: Yeah, and I think a lot of it is managing our own, you know, brain. Sometimes we have so much information at our disposal that we think that everything matters. So the key is setting out the trip wire before you enter into that decision to invest in something. That's when you're doing the most kind of underwriting work on that particular idea. Because I think that sometimes when you're in the moment, let's say, you know, a tweet hits the market, or a release comes out that doesn't have to do either thesis. But we're long in a certain region and that region really sells off due to the economic data release. But it doesn't have anything to do with our original thesis. It's really managing your own brain. I mean, the reason why we have these rules of thumb as investors is because we have so much information -- a lot of that information seems valid when it's actually really noise. Let me let me ask you a question. Roman, where you said, you really see a wide swath of different client behavior from, you know, advisors from institutions and whatnot, what do you see in terms of trends on decision-making? What are good ways to make decisions, what are some practices that you've seen that you would want to share with our audience?

16:46

Roman: And I think it goes right into what you're talking about as well. And I think that that last point you were making about a trip wires is a nice way to kind of segue into the two main things that we're talking about here is condensing your decision-making into focusing on the things that are really going to drive the needle for the investor’s return. In our case, it's those key risk decisions, we're talking about those in the advisor’s case, it's, you know, from where we sit, it's managing the asset allocation, managing, like you were talking about. And that 60/40 example, you know, the thing that will have the biggest effect versus a 60 equity, 40 fixed, versus a 40 equity, 60 fixed is that 20% change of equities -- that's going to be the main driver of that client’s return, not the managers you select for either allocation. So managing the asset allocation plan is huge. You got to get that right. But then the second thing is managing the client. I was actually having a conversation with an advisor today about this. A lot of the beliefs that you're talking about and how we structure decision-making our portfolios is because we do believe that short-term volatility is a risk. And the reason why we believe that is because volatility triggers bad decision-making in clients who don't understand markets. So the trick with what an advisor really needs to be focusing on is, how do you a manage the expectations correctly before the client has invested in the portfolio? And let them know, okay, we're getting this asset class exposure, because this is the rate of return that you need for this objective. It's going to have volatility in these types of environments. And as long as we stay the course, this is historically what has transpired. So setting those expectations before the client ever gets invested is absolutely crucial. And it goes back to what you're saying about trip wires. You put your trip wires in place before you decide to execute on the trade. I think to answer your question that managing the asset allocation, managing the client’s behavior and their expectations of what they're going to get from this investment journey is probably the best way to go about it.

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